4/25/2008 @ 10:37AM

Rethinking Fed Policy

Next week, the U.S. Federal Reserve is likely to cut the target federal funds interest rate by one-quarter point to 2%.

Observers will focus on the accompanying policy statement for clues as to whether the Fed will take a pause in cutting interest rates. And they will wait to see if the 3.25-percentage-point reductions since June–and the various special lending facilities to bolster bank reserves initiated since December–have their intended effects on domestic economic activity. Also, several Fed policymakers and observers are concerned that continued interest rate cuts could sustain inflation, which is expected to tail off over the next year.

To date, Fed efforts have not increased bank lending, domestic demand for goods, and services or inflation. The latter is being driven by the tight supplies of oil and other commodities on global markets, and the ill-conceived U.S. ethanol program.

Shortages of mortgages for worthy home buyers and credit for sound businesses persist. Home sales, new-home starts, nonresidential construction, durable goods orders, retail sales, new jobs and most other indicators of economic vitality are either contracting or limping along at recessionary levels.

Banks are not lending money because they can’t bundle new mortgages and business loans into bonds and sell those securities to insurance companies, pension funds and other fixed-income investors.

Stuck with risky securities and losses by the banks in the subprime debacle, investors no longer trust the banks and bond-rating agencies paid by the banks to certify the soundness of subprime-backed securities. The financial market reforms proposed by U.S. Treasury and G7 finance ministers do little to address these basic structural problems.

Federal Reserve Chairman Ben Bernanke will not find the answers to these problems in economics textbooks. In addition to adjusting interest rates and bank reserves, Bernanke needs to sit down with the largest banks and fixed-income investors to define simpler, more transparent loan-backed securities that bond-rating agencies can more reasonably evaluate and that fixed-income investors can purchase with confidence. Payment for the services of bond-rating agencies must be shifted from the banks, which create the bonds, to large fixed-income investors, who rely on the veracity of their assessments.

Domestic demand has been weighed down in recent years by a growing trade deficit. Americans spend about 5% of what they earn on imports, which don’t power purchases of U.S.-made goods and services. The economy has been propelled by consumers borrowing to spend more than they earn, and that string has run out.

The decline in the dollar against the euro and other market-determined currencies has helped boost exports, but the soaring cost of imported oil and imports from China and other Asian countries keep the annual trade deficit in the range of $700 billion.

Governments in China, Japan and other Asian export juggernauts intervene in currency markets to keep the yuan, rupee, yen and other Asian currencies artificially cheap, and that subsidizes their sales in U.S. markets and makes U.S. exports too expensive in Asia.

Bernanke has recognized, at least in the case of China, that currency manipulation provides an export subsidy. Though it would break the Fed détente with Treasury, it is high time Bernanke stated publicly that it will be virtually impossible to get the U.S. economy on a sustainable growth path if the dollar remains so overvalued against Asian currencies and the U.S. continues large trade deficits with China, Japan and other Asian countries.

President Bush and Treasury Secretary Henry Paulson have not even been willing to acknowledge Bernanke’s observation about Chinese subsidies and do little more than talk with Asian central banks, which keep the currencies well above market-clearing values.

Monetary policy, which by definition adjusts short-term interest rates and bank reserves, has little effect if banks are shut out of securities markets to convert their loans into bonds. Simply, monetary policy requires public confidence in the banks, and the most important component of the public, fixed-income investors, has little confidence in the banks.

In a globalized economy, monetary policy can’t boost demand for domestic goods and services if exchange rates are misaligned, and consumers spend a good deal of the money they borrow on imports but exports don’t keep up with those purchases.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.